Trusts first appeared in English law during the 11th and 12th centuries to protect the rights of landowners who travelled to fight in the Crusades. The Court of Chancery established the principle that the ‘benefit’ of a property did not always belong to the person who held the title deeds. This point remains the cornerstone of trust law.
Another common use of trusts emerged in the 15th and 16th centuries, when death duties were avoided by transferring property into common ownership.
A trust is an arrangement under which the owner of an asset and the beneficiary are not necessarily the same. The parties involved in trusts are:
1 The settlor: the person who “settles” property or assets into trust.
2 The trustee: the person who manages the trust property for the beneficiaries.
3 The beneficiary: the person who benefits from the trust property. English law requires that all trusts, apart from charitable trusts, have at least one beneficiary.
In many trusts, it is possible for the same person to hold multiple roles. Legally, these roles are treated as separate. For example, a settlor might also be a trustee and a trustee might also be a beneficiary.
It is unusual, however, for a settlor to be a beneficiary, because they may fall foul of gift with reservation rules that govern lifetime gifts.The main purpose of many, but not all, trusts is to remove property from a settlor’s estate. If the settlor survives for seven years following the date of the settlement, the property will fall outside his or her estate for the purposes of IHT (see table: Seven-year rule).
Trusts can also be set up after death through a will or through the laws of intestacy (in which case the bequeathed assets will be subject to IHT).
Since a change to the IHT regime on 22 March 2006, most trusts can be categorised as either relevant property (RPR) trusts or non-RPR trusts. The most common RPR trust is a discretionary trust; the most common non‑RPR trust is an absolute (also known as a bare) trust.
The ways these trusts mitigate IHT vary. As a rule, the more flexibility or control the settlor wants, the less IHT‑efficient they become.
Discretionary trusts
Discretionary trusts grant the trustees discretion over the identity of beneficiaries. The trust document may list beneficiaries, or classes of beneficiary, but ultimately the trustees can choose to whom they distribute income or capital.
This discretion can be particularly useful if, say, beneficiaries have lifestyle problems that mean it may not be appropriate for them to receive a large sum at a certain time. Similarly, trusts can help protect assets when beneficiaries are going through bankruptcy or divorce proceedings: since the trustees have discretion over whom to pay benefits, the courts cannot usually order that they are paid to other parties.
However, this flexibility comes at a price. Transfers of assets into trust are classed as chargeable lifetime transfers (CLTs), which means the value of assets above the nil-rate band (NRB), currently £325,000, will be subject to a tax charge of 20 per cent. This is ‘grossed up’ to a higher figure (usually 25 per cent) if the settlor pays it. If the settlor dies within seven years, a further charge of up to 20 per cent may be incurred.
When relevant property (and virtually all property is ‘relevant’) is transferred out of the trust, IHT is charged up to a maximum of 6 per cent on the amount transferred (an ‘exit charge’). At each 10-year anniversary, there will also be a periodic IHT charge of up to 6 per cent of the trust’s assets above the NRB.
Loans made by trusts are not subject to exit charges, so they can be an efficient way of removing capital from a trust, particularly as a loan will also create a debt against the beneficiary’s own estate when they die. This could also help to reduce the beneficiaries’ IHT liability. Loans still count as assets for periodic charges.
Trustees pay income tax, in the year 2016/17, at a rate of 45 per cent, or 38.1 per cent on dividends. Trustees may decide, therefore, that it is be better for the trust to invest in non-income producing assets.
However, when the trust assets consist of investment bonds, care should be taken not to fall foul of chargeable event rules by assigning bond segments in lieu of the loan (that is, for money’s worth). This could see the trustees pay up to 45 per cent in income tax without top-slicing relief. Cash loans that fall within the 5 per cent allowances would not normally be caught out by this.
The assets in a discretionary trust do not form part of beneficiaries’ estates for IHT purposes and are disregarded when calculating means-tested benefits.
Interest in possession trusts
In an interest in possession trust, a beneficiary has an immediate right to all the income produced by the trust’s assets, although another beneficiary may have rights to the capital. They are often used to provide a surviving spouse with a lifelong income while giving the children the right to the capital.
Since 2006, these trusts have largely fallen under the RPR regime. They are taxed similarly to discretionary trusts, although income tax is payable at the beneficiary’s marginal rate, rather than the rate for trustees.
Absolute (bare) trusts
These are the simplest type of trust. The settlor makes a gift into trust, which is held for a specified beneficiary or beneficiaries, usually minors. The gift is classed as a potentially exempt transfer (PET) for IHT purposes, so there is no tax to pay on entry. As long as the settlor survives for seven years, the value falls outside their estate.
However, the trust fund will form part of the beneficiary’s estate from day one. Income from trust assets is taxed against the beneficiaries. This is particularly useful if the beneficiary is a minor. If the settlor is the parent of the beneficiary, any trust income over £100 is taxed on the parent, not the beneficiary.
The beneficiary of an absolute trust is entitled to the property at 18, regardless of personal circumstances. There is no protection against claims by third parties, such as in cases of divorce or bankruptcy.
Adam Wareing is head of paraplanning at Clarion Wealth Planning
Grasping the nil-rate band
Trusts enjoy their own IHT nil‑rate band, and it remains possible to settle property up to the nil-rate band on multiple trusts as long as the settlements are made on different days. This area has previously drawn the Treasury’s attention, and abolishing multiple nil-rate bands could potentially be seen as a ‘soft target’ by the new chancellor, Philip Hammond.
Between April 2017 and April 2020, the government is phasing in the new residence nil-rate band. This will provide an additional IHT allowance when certain types of residential property are bequeathed to lineal descendants. Therefore, it may now be less appropriate to transfer or bequeath a property to a trust.
Key points
• A trust is an arrangement under which the owner of an asset and the person who benefits from it are not necessarily one and the same.
• Discretionary trusts grant the trustees discretion over the identity of beneficiaries.
• The beneficiary of an absolute trust is entitled to the property at 18, regardless of circumstances.
